Predictions for the insurance-linked security and weather risk markets in 2010

Regular readers of Artemis might remember our article from a year ago which asked some of our industry friends for their opinions on the prospects for insurance-linked securities and weather risk management for 2009. Looking back at that article, a lot of the predictions were accurate and it ended up being the most viewed article of the year. We’ve done the same again this year and asked them to give us their opinions on how the market is likely to develop during 2010. Please let us know your thoughts and add your expertise and insight to this article using the comments form at the foot of the page.Barney Schauble, PrincipalNephila Capital

We think that the two trends we noted last year will continue to develop in 2010. Consolidation and greater capital concerns continue to drive demand for secure (collateralized and/or highly rated) risk capital in order to hedge exposure to natural catastrophe and weather risks. Re/insurance carriers, utilities, agricultural companies and others are already seeking larger limits of protection and are facing a smaller pool of traditional risk capital. Catastrophe bond issuance has improved to a level where maturities and new issuance are roughly equivalent, but many buyers of protection still prefer private solutions.

Institutional investors are now much more aware of the benefits of allocating capital to these (non-correlated) sectors. The flow of capital from sophisticated investors around the world (pension funds, endowments, family offices, etc) did grow meaningfully in 2009 and we expect that to continue in 2010.

In an uncertain post-recessionary environment fueled by government spending and near-zero interest rates, business and financial companies appetite for holding risk will likely remain lower in 2010. This mindset will favor financial instruments such as catastrophe bonds and weather derivatives which offer a distinct advantage for helping minimize risk exposure. In addition the sheer potential of these markets remains enormous. For example the Department of Commerce estimates that more than $1 trillion of U.S. economic activity is exposed to weather. Even if a small fraction of new risk is hedged through derivative contracts, 2010 will be a very good year for these markets.

We continue to believe that financial companies, banks, and hedge funds, will look to non-correlated alternative markets to better control their risk exposure in 2010. Cat bonds are only weakly correlated, while weather derivatives are almost entirely uncorrelated with major investment classes such as stocks, insurance, currencies, and bonds. So diversifying a portfolio will only marginally increase total portfolio risk while greatly increasing potential returns. Weather derivatives also offer an advantage over traditional insurance markets in that they provide offsetting risks.

Hedging to control operational costs and/or lock revenue will continue to be equally important in 2010 as many companies remain in recovery mode and can not afford to hold as much risk. Including weather into a risk management program allows companies to move beyond traditional base contract structures to incorporate volumetric protections.

Further supporting 2010 growth in these markets is the fact that the worlds largest exchange, CME Group, remains dedicated to supporting these alternative investment classes.

The cat bond market thrived in the Fourth Quarter of 2009 and 2010 should produce more of the same supported by a growing investor base. As usual, we expect to see the bulk of the issuance focused on non-investment grade offerings covering peak natural catastrophe risks (and extreme mortality risk). As conditions continue to improve we may also see selected issuance covering non-peak risks in 2010. Some investment grade issuance may occur in 2010, but this is more likely to occur in 2011. With the return of investment grade issuance, we may see selected ILS beyond cat bonds.

From a structural standpoint, 2010 will also see some innovation to help expand issuance volume in 2010. Further standardization, to the extent it meets multiple sponsors’ needs, can modestly reduce transaction costs and increase transparency. However, with an increasingly frothy market, opaque collateral and trigger structures may receive support as some quickly forget the lessons of the recent past.

The bottom line is that 2010 may prove the best year for the cat bond market since 2007.

J. Scott Mathews
WeatherEX LLC

In 2010 the weather market will finally land “right side up.”

The weather market was built upside down, which is quite a feat, even for financial engineers. What we mean is that it started on the wholesale level without any retail underpinnings. It started out like a castle in the air.

There could be no bonds or interest rate marketplace without the original concept of the IOU. Corporate equities would not be where they are today had the idea of business ownership not evolved from the primary activity of delivering goods and services to individual customers several centuries ago. The global foreign exchange market is the natural outgrowth from the first seashell necklace traded for a fox pelt or spear head. Yet the weather market hit the road in the 1990’s with no simple reference to a basic deal, and now it is finally gravitating in order to establish that missing foundation.

The changes coming in 2010 for the weather derivative market will be keyed “from the bottom up.” Solutions companies such as Guaranteed Weather and WeatherBill who bring management choices to “ground level” risk holders are helping to complete a strong base to keep that castle from crashing on us. Information portals such as First Enercast Financial are opening up the world of weather risk transfer to commodity futures users across the board, delivering weather forecast intelligence as an overlay to its timely coverage of energy market action.

We are seeing this base as crucial to bringing the weather derivative exchange process to maturity in the coming year. The new weather products launched at CME Group will continue to fill the void and give us more control of the dollars that sway in the balance of Mother Nature’s whims. A year from now we expect to see this completion.

Insurance Linked Securities continue their success story and enjoy attention as an uncorrelated and interesting asset class whose performance has been within expectations over the past year. Demand in 2010 will come from both sides of the balance sheet: developments in collateral structures and increasing standardisation and index access is opening the asset class to more investors, while insurance companies, driven by Solvency II and balance sheet efficiency, and following the crisis in the banking market in the last few years, are increasingly using the capital markets (for funding and capital) rather than the traditional use of the re-insurance and banking markets, and are identifying more liabilities eligible for securitisation. Data quality and analytical support remain key factors underpinning the development of this market.

End.

Many thanks to all who contributed!

Please do let us know your opinion on the prospects for our markets in 2010 using the comments below, and remember if you’d like to be published on Artemis just contact us.

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